Wall Street just sent a strong hint to tech investors

Nov. 12, 2013
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John Shinal, technology columnist for USA TODAY. / USA TODAY

by John Shinal, USA TODAY

by John Shinal, USA TODAY

SAN FRANCISCO -- If a leading Wall Street investment bank now believes the Internet sector provides no more value than the broader technology market, folks sitting on big capital gains in social media companies may want to give themselves an early holiday gift.

Namely, some holiday spending money, by turning into cash at least some of the paper profits held in LinkedIn and Facebook, whose shares have surged roughly 90% and 70% this year, respectively.

The investment call by Morgan Stanley to its wealthy clients, as reported in USA TODAY, is a warning to those who've come late to the Internet 2.0 party and still expect to make big returns quickly.

Don't count on it, says the bulge-bracket bank that was lead underwriter of the LinkedIn initial public offering, the May 2011 IPO whose first-day surge ignited this second Internet boom.

Since then, the Nasdaq is up 40% â?? including a 26% surge this year -- as the broader stock market has digested more than $170 billion of new technology valuation, most of it courtesy of Facebook, LinkedIn and -- now -- Twitter shares.

The yellow flag from Morgan Stanley comes on the heels of Twitter's massive IPO, in which the fast-growing-yet-unprofitable upstart was able to raise more money than Google did in its 2004 offering.

Google, market veterans will recall, has been generating net income for common shareholders since its first year as a public company.

Twitter, on the other hand, is only profitable when judged by an accounting metric that's the new standard for how Wall Street evaluates Internet companies.

The new metric -- called adjusted cash flow -- ignores the cost of stock-based compensation that dilutes the value of stock held by common shareholders.

Considering all that, retail investors may want to ponder whether the year-end stock surge sometimes called the Santa Claus rally has come early this year, like the holiday decorations.

Why save on taxes -- by holding profits through year's end -- what you can spend on presents?

That's not to say the current Nasdaq bull market, powered in part by successful social media IPOs, doesn't have a leg or two higher to go over the next few months.

When mutual fund managers and the investing public arrive late to a party, as they may have done in rushing to the Twitter IPO, the sheer momentum of their money can push stocks to valuations that appear unsustainable, yet continue to rise.

For example, the Nasdaq rose five-fold in the five years after Netscape Communications ignited the dotcom boom in August, 1995, when its IPO shares doubled on their first day of public trading.

And the Nasdaq -- unlike the Dow Jones Industrial Average and the S&P 500 Index, which have hit repeated highs of late -- is still 20% below its dotcom era perch of 5,000.

In other words, the social media-powered Internet bull market may still have room to run.

Yet trying to spot a market top is best left to professional money managers and stock analysts, like those employed by Morgan Stanley.

As of the close of trading Monday, Twitter's valuation of more than $24 billion nearly matched that of LinkedIn, at just over $25 billion.

That means the stock market is now valuing an unprofitable social media company higher than a slower-growing yet consistently-profitable rival.

Valuing growth on par with profitability is an investing philosophy that usually holds sway near the top of investing booms, after the easy money has been made.

Given that, Morgan Stanley's investing call, which is an opinion that investors should no longer overweight Internet stocks in their tech portfolios, makes sense.

In 2000 and 2001, after the dotcom bubble burst, the Nasdaq gave back two-thirds of its post-Netscape gains.

That same index has gained a whopping 160% during the last five years, as the Federal Reserve's easy money policies have helped turn institutional bond buyers into stock buyers.

The Fed's extra liquidity has helped prop up the valuations of these new social media companies, and last week, almost every professional money manager wanted to own shares of Twitter -- profitability be damned.

Now, one of the underwriters of that offering has sounded a warning about Internet valuations.